Earnings Per Share (EPS) : RCJ Chapter 15 (836-842)

Earnings Per Share (EPS)
RCJ Chapter 15 (836-842)

Key Issues
1. Basic EPS
2. Weighted average common shares
3. Pecking order
4. Treasury stock transactions
5. Dilution
6. Diluted EPS
7. options and warrants: treasury stock method
8. Convertible bonds and preferred stock: if converted
method
9. Determining dilution vs anti-dilution
Paul Zarowin 2
Basic EPS
Net income - Preferred dividends
Basic EPS 
Weighted average number of common stock outstanding
 weight shares outstanding by fraction of year;

 changes due to share repos, issuances, option
exercises, etc..
Paul Zarowin 3
Basic EPS - Example
 On January 1, 2001 Solomon Corporation had:
 160,000 common shares outstanding.
 10,000 preferred shares, $100 par value, 7%
 On September 1, 2001 the company issued 40,000
additional common shares.
 The net income for 2001: $1,257,331
 What is the basic EPS?
Preferred dividends = 10,000 x 100 x0.07 = $70,000
(a) Shares (b) Portion Weighted shares
Time span outstanding of year (col. a x col. b)
Jan 1 - Aug 31 160,000 2/3 106,667
Sep1 - Dec 31 200,000 1/3 66,667
173,333
$1,257,331 - $70,000
Basic EPS   $6.85 per share
173,334 shares 4
Basic EPS (cont’d)
EPS is from common shareholders’ viewpoint
Pecking order of suppliers of capital:

1. Debt holders
2. Preferred stock holders
3. Common stock holders
 Why are preferred dividends subtracted, but not
bond interest?
Ex. E15-14; P15-4
Paul Zarowin 5
Effect of Treasury Stock Transactions
1. Purchase of treasury shares:
DR Treasury stock (contra O/E A/C)
CR Cash
2. resale of treasury shares:

DR Cash
DR APC
CR Treasury stock (at cost, from 1.)
or CR APC
DR (or CR) to APC is economic loss (or gain) that is not
recognized in accounting
Paul Zarowin 6
Effect of Treasury Stock Transactions (cont’d)
Key point:
Transactions in own common stock don’t affect NI
(proprietary viewpoint), only affect number of shares
outstanding; so firms can manipulate EPS
Q:How does transaction timing during the year affect

EPS?
Ex. E15-16; P15-8
Paul Zarowin 7
Diluted EPS
 SFAS No. 128 requires companies with complex capital
structures to compute another measure called diluted
earnings per share.
Income adjustments due to
Net income - Preferred dividends + dilutive financial instruments
Diluted EPS =
Weighted average number of + Newly issuable shares due to
common shares outstanding dilutive financial instruments
 (1) Options; and (2) Convertible securities can:

 Decrease EPS  dilutive Only dilutive securities
are included in the diluted
 Increase EPS  anti-dilutive
EPS calculation
Paul Zarowin 8
Conversion Ratio
Income adjustments due to
dilutive financial instruments
Conversion ratio =
Newly issuable shares due to
dilutive financial instruments
 The dilutive effect of financial instruments (for

example, options warrants, and convertible bonds)
on EPS is calculated starting with the instrument with
the lowest conversion rate (i.e. most dilutive), and
working up to the instrument with the highest
conversion rate (i.e. least dilutive).
Paul Zarowin 9
Step 1: calculate the effect of options and
warrants on EPS
 Treasury Method:
Q: Option exercise price < Market price
Yes No
Options have dilutive effect  include Options do not

them in diluted EPS: have dilutive
1. Assume all options are exercised  effect  not
add new shares. included in
diluted EPS.
2. Assume proceeds (# shares x
exercise price) are used to repurchase
previously issued common shares 
subtract these shares.
Paul Zarowin 10
 Example: Now assume that Solomon Corporation issued
options to buy 20,000 shares of common stock at $100
per share. The market price is $114. What is the diluted
EPS?
 Option exercise price 100$ < Market price 114$
 Upon full exercise of option  additional 20,000
shares
 The proceeds 20,000 X $100 = $2,000,000
are assumed to be used to repurchase previously
issued common shares at the $114 market price.
$2,000,000
 17,544 shares
$114 per share
 The dilution effect: 20,000 – 17,544 = 2,456 shares
$1,257,331- 70,000
Diluted EPS   $6.75 per share
173,334  2,456
Step 2: calculate effect of convertible
securities on EPS
‘if-converted method’ (one convertible security)
 Increase in EPS denominator: calculate additional shares under
full conversion.
 Increase in EPS numerator: Calculate increase in net income if
interest had not been paid on the convertible bonds/preferred

shares.
increase in (after tax) net income
Conversion ratio=  Diluted EPS After step 1
# shares converted
Yes No
Dilutive effect: Add increase No dilutive effect: leave

in numerator and Denominator to Dilutive EPS after step 1 as-is.
Dilutive EPS.
Paul Zarowin 12
 Example cont’: Solomon Corporation also has:
 $1,000,000 of 5% convertible bonds, with par (face) value of
$1,000 per bond
 Each $1,000 bond pays interest of $50 per year and is
convertible into 10 shares of common stock.
 35% tax rate
 What is the dilutive EPS now?
 Increase in denominator: 1,000 x 10 = 10,000 shares

Increase in numerator: 1000 x $50 x (1-0.35)=$32,500
32,500
 3.25  6.75
10,000
$1,257,331- 70,000  32,500

Diluted EPS   $6.57 per share
173,334  2,456  10,000
Summary of example
Basic EPS = $6.85
(slide #4)
1. After considering effect of

options = $6.75
(slide #11)
2. After considering effect of

convertible bonds = $6.57
(slide #13)
Q: Why does dilution effect of options always come before convertibles?
Paul Zarowin 14
If converted method with multiple
convertible securities
Rank all convertible securities by conversion ratio; take
convertible with lowest conversion ratio*
For the chosen convertible security check:

increase in (after tax) net income
 Diluted EPS After step 1
# shares converted
Yes: Dilutive No: Anti-dilutive
Calculate New EPS Stop
Take the convertible with the

next lowest conversion ratio
* Options have lower conversion ratio, therefore come before convertibles.
Paul Zarowin 15
Exercises
 E15-14
 P15-4
 P15-12
Paul Zarowin 16

Earnings Per Share (EPS) : RCJ Chapter 15 (836-842)

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Earnings Per Share (EPS)

RCJ Chapter 15 (836-842)

 weight shares outstanding by fraction of year;

Pecking order of suppliers of capital:

Ex. E15-14; P15-4

2. resale of treasury shares:

Q:How does transaction timing during the year affect

Ex. E15-16; P15-8

 (1) Options; and (2) Convertible securities can:

 The dilutive effect of financial instruments (for

Options have dilutive effect  include Options do not

interest had not been paid on the convertible bonds/preferred

Dilutive effect: Add increase No dilutive effect: leave

$1,257,331- 70,000  32,500

1. After considering effect of

2. After considering effect of

Q: Why does dilution effect of options always come before convertibles?

For the chosen convertible security check:

Yes: Dilutive No: Anti-dilutive

Calculate New EPS Stop

Take the convertible with the

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